Tax saving funds may soon withdraw the dividend re-investment option as the Association of Mutual Funds in India (Amfi) has issued a best practice circular asking fund houses to discontinue the option under equity-linked saving schemes (ELSS).

Investments up to Rs 1.5 lakh in ELSS are eligible for deduction under Section 80C of the Income Tax Act. The money invested in these funds has a lock-in of three years.

Tax saving funds offer both growth and dividend options. The dividend option comes with a dividend payout and a dividend re-investment option. In case of the dividend payout option, the investor is paid the dividend declared. Under the reinvestment option, the dividend declared is reinvested in the fund and is considered as a new investment and so is locked in for three years.

Although the dividend amount reinvested is also eligible for deduction under 80C, this creates an unending loop, where every dividend announced gets locked in for the next three years, making it difficult for the investor to withdraw the entire amount at one go. To get rid of this problem, Amfi has asked fund houses to withdraw the option.

If you invest in an ELSS on January 2015, your money will be locked-in till January 2018. If the fund declares a dividend on March 2015, then under the dividend reinvestment option, the dividend amount thus invested will be locked in till March 2018. Now, suppose you want to withdraw your investment in March 2018, but the fund declares dividend in February 2018. The amount of dividend would then be locked in till February 2021. Therefore, A part of your money will always remain invested in the fund.

Manoj Nagpal, a financial advisor said "This is a logical move although very late. In ELSS, the investment size is generally very small, which results in a lot of angst among investors as it is impossible to withdraw the full amount."